FTA Vantage Point: Interest Rates  

The impact of higher interest rates on equities

  • To discover how interest rate movements impact equity markets
  • To understand how equities perform at different stages of the economic cycle
  • To understand the longer-term outlook for equities
CPD
Approx.30min
The impact of higher interest rates on equities
  FT montage/Getty Images/Reuters/Bloomberg

Investors in equity markets are experieincing an especially volatile period at present, due to an unprecedented set of circumstances.

Perhaps the data point that best illustrates the challenge faced by them is that in November 2020, as the UK readied to enter a new set of restrictions, Jerome Powell, chair of the US Federal Reserve, said that while the market had risen 25 per cent in the eight months since the start of the pandemic, he did not regard it as overvalued. 

For roughly the following year equity markets battled to fresh highs, despite the wider world whipsawing into and out of restrictions and millions of businesses shut down and started up again.

Despite such volatility, central bankers remained optimistic as equity markets kept rising.

This optimism continued well into 2021, with a majority of Powell’s colleagues at the Fed declaring there would be no need for interest rates to rise until 2024.

However, this sentiment has completely reversed, and now policymakers have shifted their stance.

The rocky start endured by equity investors since the start of 2022 has coincided with a shift in tone from US policymakers, with expectations now that rates could rise this year, while the central bank’s bond buying programme would also wind down.

Policymakers in the UK and Eurozone have similarly pivoted in recent weeks to a position where they favour tightening monetary policy in the near term, raising questions of where this leaves equity markets in the short to medium term.

Higher interest rates are usually considered negative for equity markets for a number of reasons, though it depends on the stage of the market and interest rate cycle.

Economies generally move through four phases of a cycle; from recovery, to expansion, to downturn, to recession. 

In the recovery phase, equities will usually be lowly valued due to a recent economic downturn, while in the same period, it is likely that only a relatively small number of listed companies are growing, so it is these businesses that investors buy, and which rise in value.

As this is happening when growth in the wider economy is weak, the equities are usually called 'growth shares'.

In the years immediately after the financial crisis, growth shares performed very strongly, a pattern that continued almost without interruption until the announcement of the first Covid-19 vaccine in November 2020.

Eric Theoret, global macro strategist at Manulife, says that economies can remain stuck at points in the cycle for an extended period, and believes this happened since the global financial crisis, with many developed world economies stuck in the recovery phase, with low growth and low inflation, and growth shares performing well. 

He says it is possible to “alternate between” the recovery and the expansion stages for a long time without ever entering the recession stage. 

Interest rate policy in such a climate is predicated on the economy being well into the expansion stage, with inflation rising as demand outstrips supply.